Tax Efficient Strategies for Converting to a Roth IRA
by Shane Flait (2009)

 

As of 2010, anyone – no matter how high his income – can convert all or any part of a qualified plan to a Roth IRA. But converting from a qualified plan – like a traditional IRA – requires paying income taxes on the amount that you convert into your Roth IRA.

 

This article suggests some ways to get the most benefit out of your conversion while minimizing the taxes it produces – especially for high earners.

 

Benefits of a Roth IRA

I should mention that high earners are still prevented from contributing to a Roth IRA. But they at least can make a conversion to one. Roth IRAs are beneficial for higher income retirees because:

·        Roth IRA funds grow tax free and withdrawals are tax-free. Both mean your money in a Roth is protected from loss to taxes forever.

·        Roth owners and their beneficiary spouses never have to make Required Minimum Distributions (RMDs) after turning 70½. This means their not required to begin depleting this tax-free saving vehicle and can hold it as a legacy.

·        Withdrawals from a Roth IRA are not includable as income so they won’t push your Social Security income into being taxed – or taxed more.

·        Though nonspouse Roth IRA beneficiaries must make MRDs when they receive them, these MRDs remain tax free and are usually so small for younger beneficiaries that their inherited Roth IRAs grow for many years for their own retirement. This makes a Roth IRA a good way to transfer wealth.

 

Strategies to making the conversion efficient

Your first move is to pay your conversion tax with money other than your qualified plan money.

Suppose you have $100,000 of your traditional IRA for converting to your Roth IRA. If you use this money to pay the tax on the conversion, then you’ll end up with only a fraction of it in your Roth. That would rob you of tax free investment money.

As an example, if the conversion is taxed at 33% marginal tax rate, you’ll lose $33,333 of that money to taxes while ending up with only $66,667 in your Roth IRA. So aside from paying all that tax, you’ve got a lower Roth IRA value for further growth. You had the advantage of $100,000 growing tax-deferred traditional IRA. The conversion law lets you put the full $100,000 into your Roth IRA.  So you’re left with the advantage of the full $100,000 growing tax-free. That’s an important benefit. But to reap it you’ll have to pay the conversion tax with other money.

Lowering the marginal tax rate on your conversion

Before considering options for using ‘other’ money to pay your conversion taxes, realize that splitting up your conversions over different years allows a lower yearly converting amount to relieve the possibility being taxed at very high marginal tax brackets. Generally you must pay the conversion tax for the tax year in which you make the conversion.

But the law makes an exception for those who decide to convert to a Roth during 2010. It allows them to divide the taxes on the conversion between their 2011 and 2012 federal returns. So they can make the complete conversion in 2010 but split the conversion amount equally between those later year tax returns. That can really low the marginal tax bite on the conversions and give tax-free growth everything starting in 2010.

Options for paying conversion taxes with ‘other’ money

One benefit of being a high earner is that you may have a lot of nonqualified investments which you can tap for paying the conversion tax.  Let’s see what you might choose.

You can tap your bank account or what you’d normally put in CDs. Though you’ll be losing this money and whatever interest rate it earns, you’re allowing that same amount of money to sit in your Roth IRA growing tax free. It’ll grow faster there.

If you have stock or similar equity investments, decide not to sell any winners to reduce capital gains from pushing up your taxable income in the year of conversion. Instead, choose losing equity investments that can produce a capital loss for you. That’ll reduce your taxable income or, equivalently, offset your tax bite which includes the conversion tax.

Take out an equity loan on your house – for the short term – to pay the conversion tax. You can take a deduction for loan interest charges if you itemize your taxes. Remember, you’re effectively preserving this amount of money to grow tax free in your Roth. Resolve to pay the loan off in a few years.

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com